The fortunes of the Australian stock market are closely tied to the US, and rising defaults in sub prime sections of the US mortgage market have investors in both markets spooked. The collapse of two major US hedge funds, run by the reputable US investment bank ‘Bear Sterns’ has highlighted the fact that it is more than the original lenders at risk of this ‘toxic debt’.

But… will the Aussie market be affected?

Operators in the sub prime mortgage market make loans to people who fail to meet regular credit standards. As the risk of default is higher, the loan usually carries a higher interest rate to compensate the lender.

Financial engineering has allowed non lenders to invest in these loans by purchasing the right to receive the interest payable on loan. However investors in these products, which are often known as Collateralised Debt Obligations (CDO) and Mortgage Backed Securities (MBS), also take on the associated default risks.

The securitisation process gives sub prime lenders little incentive to be prudent when making loans, as it allows them to realise the value of the loan today while transferring the risk to another party. So should the mortgagee default on payments, it is no longer the lender’s problem.

Investors who buy into these products, primarily banks, insurance companies, and pension and hedge funds, bear the brunt of any losses. The attraction stems from the relatively high interest rates on offer, relative to what may seem to be comparable fixed interest investments. In this unregulated market, there is little information available on the assets underlying these products, and thus investors have been unable to properly appreciate the risk involved.

With over $500 billion of CDO’s issued globally last year, there is a lot at stake should default rates continue to rise. Any broadening of this financial crisis would almost certainly play havoc with global stock markets.

How can Australian investors protect themselves?

The long term outlook for the Australian share market remains sound; however short term weakness could arise should the yarn unravel further on the US sub prime crisis.

Here at wise-owl.com, we believe investors should focus less on the overall market and more on individual companies. No matter what the general market conditions, there will always be stocks that outperform. The key to successful investing is identifying these companies so that you can make money regardless of what the market is doing.

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